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Spotify's pursuit of a direct listing instead of an IPO is a mistake, venture capitalist says

  • The risks of Spotify's eventual direct share sale outweigh the rewards, David Golden says.
  • While the company can avoid costly underwriter fees, it will lose the other forms of value that investment banks provide.
  • A direct listing may be a solution looking for a problem.

The news that music streaming service Spotify will go public later this year or early next using the relatively uncommon method of a direct listing has everyone in the tech and finance communities talking.

Even the SEC is studying Spotify's plan to skip a traditional IPO in favor of a direct public offering, or DPO.

The big questions on everyone's minds are: Why? Will it work for Spotify? And what does this mean for other tech start-ups looking to go public?

Before diving in, it's worth considering why a company goes public in the first place. There are three principal reasons. First and foremost, it's a financing transaction. In an IPO a company sells newly issued shares to the public for cash and uses that money to run its business, develop new products, hire more people and pay off debt. In almost all cases, companies hire Wall Street underwriters to conduct the public offering by curating investors, building the book of orders, pricing the stock and trading it after the IPO.

Second, going public provides liquidity to the company's stakeholders. Typically, venture capital investors in the company may sell some shares in the IPO or they may distribute shares to their fund investors, who can then sell or hold their stake. Company employees with stock or options also have a way to cash out, at least in part, either at the time of the IPO or more commonly after the traditional underwriter lock-up expires six months later.

Third, going public gives the company another form of currency to make acquisitions. Once public, it's much easier for a company to use its own stock to acquire another company because the stock has a determined value.

Based on my conversations with various Wall Street bankers, the first rationale — raising money — doesn't apply to Spotify, because it doesn't look like the company will be selling any of its primary shares to raise cash, at least not for a while.

Rather, Spotify is merely filing the paperwork under the Securities Exchange Act of 1934 that makes it legal for anybody to trade the shares. As for the price of those shares (and the resulting valuation of the entire company), that's up to the market. While the company isn't raising any capital for itself, the direct listing allows shareholders and employees to get liquidity, and it allows the company to get acquisition currency for future M&A.

So what's motivating Spotify to take this unconventional approach?

First, Spotify may simply not need the money right now. Having raised over $2.5 billion in the private debt and equity markets, Spotify may have concluded that the private markets will continue to fund the company's losses for the foreseeable future.

There are other advantages to avoiding an IPO. The company doesn't have to hit the road to meet with hundreds of investors or pay substantial underwriting fees to Wall Street banks. There's no risk of being embarrassed if the shares trade down from the offering price because there is no offering price. The market will speak and the share price will find its natural level over time. Moreover, because the company is not selling any of its own securities, there's no quiet period prohibiting public commentary on its business and operations. Indeed, Spotify could even publish its own equity research report about its business.

Providing liquidity

The second rationale for a public offering — liquidity for shareholders — is probably a significant motivation for the direct listing. The company provides a path for patient investors to sell their shares as soon as the listing is effective. There's no underwriter lock-up and there's no dilution to existing shareholders because the share count doesn't increase, as it does with a traditional IPO.

There is an additional advantage for Spotify. When the company sold convertible notes to TPG and Dragoneer Investment Group last year, it was widely reported that those notes carried a provision that lowered the conversion price with each passing quarter that the company remained private. A direct listing would stop the clock and keep Spotify from incurring additional dilution.

From Spotify's perspective, there is an elegant logic at work here — list the shares, be publicly traded, avoid underwriter fees, stop the clock on the convertible notes, get acquisition currency, avoid the embarrassment of a mispriced offering (see Blue Apron) and decide to raise cash at some other time when the price has settled in the public markets. And, of course, avoid the hassle of going public.

At the same time, a direct listing seems to be a solution looking for a problem. The hassle of going public is nothing compared with the hassle of actually being public, and the direct listing does nothing to address that.

All of the business preparation, due diligence, prospectus drafting, SEC engagement and oversight are part of the direct listing process, and the forms required for such a listing are substantively the same as those required for an IPO filing. The only real obstacle a direct listing avoids is the two-week roadshow that management uses in an IPO to meet with investors and tell a story.

While exhausting, most management teams find the roadshow very memorable (and have the weight gain to prove it). The meetings often afford the management team the first real opportunity to build relationships with investors that can support the company in the months and years that follow. After the direct listing, Spotify will be a public company, subject to quarterly financial reporting and accountable to many more shareholders. It's only a matter of time before Spotify will feel compelled to meet or beat Wall Street estimates or suffer the consequences.

Spotify will surely save money by not paying underwriters, and those fees can be substantial. But highly visible names like Facebook and Snap managed to negotiate significant discounts on their underwriting fees and I'm sure Spotify could do the same. There are other valuable things that underwriters do behind the scenes. They provide after-market liquidity in the shares so people can trade them easily without moving the price. Wall Street sponsorship aids in the efficiency of the capital markets and the ease with which buyers and sellers of stock can transact.

It's no coincidence that virtually every direct listing in recent memory has involved companies with less than $100 million in value that are essentially orphaned in the public markets. Ever hear of OvaScience or BiolineRX? Historically, the direct listing has been the public market debut of last resort.

If I were Spotify, I would think twice about the direct listing. It will become a public company, but not without costs. Those costs are just harder to quantify than an underwriting spread paid to an investment bank.

David Golden co-leads Revolution Ventures in the San Francisco office. He previously spent 18 years at JPMorgan (and a predecessor firm, Hambrecht & Quist), including as co-director of investment banking starting in 1998.